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February 25, 2015

Best Practices: Lender Liability, A Primer (Part 2)

by Norman E. Greenspan

The first part of this series (S&S Best Practices, December 3, 2014) addressed some of the causes of action that comprise what is commonly referred to as “lender liability.” As previously noted, there are no statutes that define what constitutes “lender liability.” “Lender liability” is merely a catch-all phrase referring to a lender’s actual or potential liability to it borrowers or third parties for claims arising from a lending relationship. In the first part of the series, the lender liability theories of breach of contract, breach of the covenant of good faith and fair dealing, and breach of fiduciary duty were discussed. In this part of the series, several other theories of lender liability are reviewed.

One of the most common theories of legal liability is negligence, which theory is often applied to the lender/borrower relationship. Many cases have been filed, with mixed results, where the borrower claims that the lender knew or should have known that the proposed project that was to be funded would not work, but because the lender was anxious to receive fees and origination points, the lender did not stop the borrower from proceeding with the loan, especially when the loan is adequately collateralized. These cases feed off of the public’s perception that lenders are greedy, and this greed blinds the lender from exercising judgment that the borrower may be relying upon. Third-party guarantors will defend against the lender’s claims against the guarantee by arguing that the lender knew or should have known that the debt would never be repaid, and knew from the outset that the guaranty was at risk.

In construction loans, the lender often distributes the loan proceeds based on the percentage of project completion. It is standard practice for the lender to retain the right to inspect the ongoing project to verify the owner’s claim of the percentage of project completion before a partial distribution. Third-party guarantors have successfully defended against the lender’s claims against the guaranty because of the lender’s failure to properly inspect the project arguing that, had a proper inspection occurred, the lender would not have made the distributions. The third-party guarantors argue that the lender knew or should have known that the project was at risk for failure to be completed with the available loan proceeds, and the lender’s delay in exercising its remedies put the guarantees at unnecessary risk.

One of the most successful theories of lender liability results from the lender’s exercise of control over the borrower or its day-to-day operations. Often, lenders require that stock in the borrowing entity be collateralized, and that the lender be given rights to exercise control of the stock upon default, including making decisions regarding the management of the borrower. However, by exercising this control, the lender risks exposure to liability to the entity and its shareholders for any harm that may result from the exercise of this control.

Lenders also should be aware that its conduct in servicing a loan may result in waiving certain of its rights. It is not uncommon for a lender to accept late payments from a borrower without declaring a default. Under these and similar circumstances, courts, on occasion, have accepted the borrower’s argument that the lender’s conduct caused the borrower to believe that it would be allowed to catch-up in its payments before the lender exercised its remedies. As a result, courts have held that the lender has waived the right to exercise its remedies for late payment without giving the borrower an adequate opportunity to get current on its payment obligations.

Lenders also face problems when its has a secured interest in assets that are subject to forfeiture claims of the government. Under various statutes, the government has the right to seize property that constitutes the fruits of unlawful activity, or which property was used in illegal activity. So, for example, a lender has a perfected security interest in its borrower’s inventory. The government alleges that this inventory was purchased with the proceeds of sales of substandard product to the government, which product constitutes the inventory in which the lender has its security interest. The government may argue that the inventory is both the fruit of the unlawful activity, and was used to defraud the government by selling substandard product, and is therefore subject to forfeiture.

In the last of this series, suggestions will be provided to lenders on how to minimize exposure to claims of lender liability. For more information about lender liability, please contact Norman at 215-390-1025 or at ngreenspan@starfieldsmith.com.